Under The Hood Of FocusShares: Q&A With Kris Wallace & Erik Liik

FocusShares launched a lineup of 15 low-cost domestic equity ETFs in March 2011 and Scottrade (an affiliate of FocusShares) offers these ETFs commission free to retail investors and advisors. Kris Wallace, head of portfolio management and product development, and Erik Liik, president and CEO, recently took time out of their schedules to discuss what makes FocusShares ETFs unique, tracking errors in ETFs, and potential for growth of the ETF industry [see also Ten New Year’s Resolutions For ETF Investors].

ETF Database (ETFdb): A lot of investors are under the impression that all ETFs are equally cost efficient – or at least that they’re all pretty close. I’m guessing you might have a different take on that?

Kris Wallace (KW): We do actually; because FocusShares took cost efficiency to a new level. You didn’t think ETFs could go any lower and we determined that they could. We have two products that are at five basis points. We targeted all of our other products either to be the lowest or among the lowest in each of their product categories.

ETFdb: For a trader who is going to be in for a few minutes or a few days that may not make a big difference. But for long term, buy-and-holders, what Jack Bogle called the tyranny of compounded costs, can end up having a huge impact.

KW: Absolutely. If you do the math over the lifetime of your holdings, expenses can become material, especially if it’s a 30- or 40-year time horizon. It really does add up year after year, compounding those expenses.

ETFdb: Beyond expense ratios, there are other components of the “total cost” of ETF investing that should be considered. What are the other aspects of the cost equation that investors should be considering? How have you structured the FocusShares lineup to address some of those issues and maintain cost efficiency on other fronts as well?

KW: One of the cost considerations is whether your ETF is tracking its index. We are happy to report that all of ours are tracking them very closely. It can be a cost if whatever you’re invested in is not tracking its particular index—if there is a considerable difference between the fund’s performance and the index performance. And if you look at our funds, we are right in line with the Morningstar indexes, be it the FMU Total Market or even down to the real estate fund. We are very happy and very proud of how our group is doing as far as making sure the indexes are being tracked closely [see also Seven ETFs To Be Excited For In 2012].

And I think that the other thing is, is obviously the zero commission for Scottrade customers trading online. If you want to buy one share, you can buy one share and it’s not going to impact the cost of that investment. Also, you want to look at the bid-ask spread. We have good relationships with our lead market makers, and they have kept a very tight bid-ask spread in our ETFs.

Erik Liik (EL): Tracking the underlying index is a major point that an investor has to look at. How well the manager does this reflects how efficiently they are running the underlying portfolios. The range of tracking differential for the first seven months for the Focus Morningstar ETFs has been as low as one basis point tracking error on our large-cap fund, with the bulk of ETFs tracking around nine basis points of their underlying index.

ETFdb: There is this assumption among a lot of investors that tracking an index is a given and that an ETF is going to perfectly replicate the index to which it’s linked. But in a lot of cases, that is really not what we see. It is not uncommon to see tracking error of 100 basis points annually or even greater than that on some ETFs. In general, what causes tracking error? Why do some ETFs not perfectly replicate their index and in some cases deviate by quite a bit?

KW: Tracking error can be caused by a number of items. We pay very special attention to the index we are tracking. One of the most important factors is how a fund handles extra cash in the funds. Effective execution of corporate actions such as acquisitions, stock splits, and so on. Recognizing funds that year in and year out closely track the underlying index of an ETF is as important has picking the index itself [see also ETF Tracking Error: Fact And Fiction].

ETFdb: It seems that a lot of the indexes underlying the popular ETFs were not designed to be used as investable assets or as the basis of investable assets. They have been around for decades and they were not necessarily constructed to one day be the basis of an ETF.

KW: Exactly, you’re absolutely correct. That is why Morningstar has addressed that when they constructed their indexes going into it.

ETFdb: There is a lot more scrutiny on indexes now that they are the basis for an investable asset. For whatever your investment objective is, what are some of the factors that are worth considering both in the index, which translates into the fund in terms of balance and diversification? What differentiates these products?

KW: It is, of course, always important to know what your goals are. I think that what I have seen in the products that we have is that our index provider, Morningstar, believes in cap-weighted benchmarks. So unless you are in a cap-weighted index, we will have small-cap, mid-cap, and large-cap exposure inside the sectors as well as the broad market. They also believe in not duplicating any one name. So if there is a particular company in the large cap fund, it’s not going to show up in the mid-cap offering, so you have no risk of double exposure. When Morningstar built their indexes, they were also mindful that maybe these were going to become investable products. They made our job a little easier. Because of the way they construct their indexes, they have lower turnover, so that cost to the fund is less and the investor benefits [see also Where The ETF Money Is Flowing (The Answer Might Surprise You)].

ETFdb: You two have been around the ETF industry for a long time. What are your thoughts on how the industry has evolved in the last few years? Going forward, what do you see as the potential growth areas for ETFs? Where do you see the industry moving forward?

EL: I’m excited about what has transpired over the last decade or the last 15 years since I got directly involved in ETFs. About 11 years ago, I worked with FRC (Financial Research Corp.) in co-authoring a study on “The Future of the Exchange Traded Fund Industry” and that report was published in May of 2000. That was simultaneous with the iShares launch of ETFs. That was really the big initial push in the ETF product area. Prior to that, there were less than two dozen ETFs. What has happened during this period – and we were pretty spot on in terms of study – is that clearly the ETF product structure has shown to be a superior delivering mechanism for investment management. It’s democratized investing.

The growth in the product landscape, in terms of assets and of variety, demonstrates that the investing public – whether retail, advisors, or traders – has clearly adopted the ETF as the delivery mechanism of choice out there. If you look at the McKinsey study, it appears that ETF growth will remain unabated at 30+% growth rates. In the future I see more products, more issuers – more for everyone.

ETFdb: Why aren’t ETFs even more popular? What is your take on why the ETF industry does not have 5 or 10 times as many assets as it does now? Is it just a matter of momentum and of education among advisors and awareness?

EL: That’s part of it, and it has always been that way. We are much further along at this point in time than where we were 11 years ago, and the percentage of advisors and retail investors utilizing those products has certainly increased. And certainly the continued education by ETF issuers and by broker-dealers on the product has helped. Once test-ridden by investors, they continue to use the products.

In terms of why isn’t the ETF industry larger, I have a few thoughts. ETFs are portable instruments, meaning they transcend global boundaries – you have Canadian investors that are buying U.S. ETFs for their retirement savings planning, you have Europeans buying U.S. ETFs, you have U.S. ETFs which are cross-listed into foreign markets. The one big missing element right now where ETFs are not on a level playing field is the 401(k) market place, which has been the bastion for the mutual fund industry in terms of asset growth. ETFs have been largely excluded from that channel. That’s going to change as the 401(k) business changes, and you have a lot more growth in the smaller TPA’s of the market place that are building 401(k) platforms that utilize ETFs [see also Financials Free ETFdb Portfolio Now Available].

You will see that trend continue. And even at larger companies, more and more are starting to look at providing ETFs through the brokerage window in their 401(k) plans. And again, if you look at firms like Scottrade and FocusShares, we provide value at low costs. In terms of an execution venue for a TPA, Scottrade can provide zero commission trading. It is all about democratization here.

Disclosure: Photo courtesy of Magnus Manske. No positions at time of writing.

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